'Costcoholics': Costco's $113.7 Billion Addicts

A good friend of mine was raving about Costco recently, going on about how she couldn’t resist shopping there at least two to three times a week. She said sometimes she doesn’t even plan on buying anything. She just loves wandering around in the enormous, double-football-field-sized warehouse, hunting for what’s new (Costco turns over its entire inventory 12 times per year). She is also obsessed by what the big designer or luxury “surprise” of the week might be — stuff like Waterford Crystal, Coach handbags or Omega watches, to name a few, all selling out quickly for shock-and-awe low prices. And even though she may have shopped with no intention of purchasing, she says she always finds something that seduces her to buy.

As she is telling me about her compulsive obsession, or obsessive compulsion, for this almost out-of-body experience she has every time she goes to Costco, I think I observe a slight tremor — almost as though she’s going through some sort of withdrawal. The next thing out of her mouth is, “I must plan a dinner party for this weekend so I can get over there tomorrow and get some steaks and another case of red wine.” Just to give you some context, world-renowned chef Julia Child bought her meat from Costco, and the retailer is the largest purveyor of fine wines in the U.S. Incredibly, to me, my friend did plan a dinner party just as an excuse to go to Costco. Now that redefines the neurological addiction I’ve been writing about for years.

She is just one of the over 75 million “mainlining” Costco members (and growing at a high single digit percentage rate annually), with an average annual income of $100,000, paying a $55 annual membership fee (or $110 for an executive level membership). Three million members a day enter Costco’s stores to get their fix.

Yes, you read those numbers right. In today’s over-stored and over-stuffed retail environment, the equivalent of almost one-fifth of the U.S. population is paying for the privilege to shop at a particular store. And this is not a one-off, let’s-see-what-it’s-like kind of visit. The renewal rate is a whopping 90 percent each year. I guess that captures the power of an addict’s behavior.

Not only is 80 percent of Costco’s gross margin and 70 percent of its operating income derived from its Costcoholics’ membership fees, Costco collects most of its profits 12 months in advance, not at the eleventh hour of the fiscal year like most other retailers.

These “druggies” bought enough stuff during Costco’s 2015 fiscal year (ended August 30), to pump revenues up to $113.7 billion (a 3 percent increase over 2014). Costco is the second largest retailer in the U.S. after Walmart, with 488 warehouses. Internationally there are 90 Costco warehouses in Canada, 36 in Mexico, 27 in the UK, 24 in Japan, 12 in Korea, 11 in Taiwan, 8 in Australia and 2 in Spain. And Costco plans to open 32 net new warehouses in fiscal year 2016.

A Combination Drug

At the core of Costco’s model is a philosophy that was embedded by its founder and CEO, Jim Sinegal, from its inception in 1983, then passed on to its current CEO, Craig Jelinek, when he took the helm in 2013. This philosophy was handed down to Sinegal by his longtime employer and mentor, Sol Price, who was the pioneer of the “warehouse store” retail model, launching Fed Mart in the 1950s and Price Club in 1976.

Price never allowed employees to use the word "discount." The way Price’s mind worked was to focus on the lowest possible markup rather than the deepest discount. In Sol’s mind, the word discount equated with cheap. So the core ingredient in Costco’s addictive drug is its value proposition that stands for high-value products at the lowest prices.

How does Costco manage to offer such down-and-dirty prices? For starters, it has enormous economies of scale. Costco buys more apple juice, diapers, pasta, towels—in fact, more of any product it decides to offer its members—than just about any other retailer, allowing it to negotiate the lowest prices from vendors. It sets the standard for the lowest pricing in the industry; not even Amazon can beat it. As a result, the Internet has disrupted Costco less than it has other retailers.

And since 80 percent of its gross margin and 70 percent of its operating income come from its membership fees, Costco keeps margins razor thin, with markups at 15 percent or less, compared to 25 percent for supermarkets and 50 percent for department stores. Costco’s prices are on average 30 percent below large supermarket chains’.

Because of the relatively low number of SKUs that Costco carries, the Costco model is simpler, cheaper and easier to execute, and it is inherently more productive than that of the average retailer. It requires less time to sort, restock, reorder and deliver product. Costco eschews carrying multiple brands of products that are similar, except of course when it has its Kirkland Signature private label brand to sell. Think about it: A major supermarket chain like
Kroger’s might offer 40 different peanut butter SKUs; Trader Joe’s has ten; and Costco? It has two. Costco’s 4,000 total SKUs is narrow, but it allows them to buy huge quantities and charge lower prices.

A second part of the Costco drug combo is the treasure hunt—the discovery of something not needed, but impulsively desired. Each store’s main aisle is designed in a racetrack layout, which leads customers to circle the entire floor and view the entire mix of product offerings, often enticing them to buy things they didn’t necessarily set out to buy.

Costco’s product categories range from tires and diamond rings to food, clothing, electronics, cleaning supplies, home décor items and everything else in between. And don’t forget gas and the automobile aftermarket. More than 66 percent of its sales are food. Approximately 75 percent of merchandise sales are in what the company calls “triggers”— bulk sales of staple products like cereal, ketchup, detergent and paper towels—that people use day in, day out. Need 20 pounds of sirloin steak or five pounds of whole cashews? Then Costco is your place. Eggs come in cartons of 90. Diapers are ten dozen to a box. You can buy Colgate Advanced Whitening toothpaste, but only in a pack of four eight-ounce tubes.

The other 25 percent of sales at Costco are in so-called treasures—opportunistic finds that Costco stocks to surprise and delight its customers. These are electronics, appliances and other less frequent purchases at extremely good prices. And then there’s the fun stuff. Brands such as Andrew Marc, Calvin Klein,
Adidas,
Chanel, Breitling and many more, for incredibly low prices, compel the treasure hunters to keep coming back. Behind the curtain, these products are acquired from distributors, rather than the brands themselves, sold individually (not in bulk)—and often sell out quickly.

The three million shoppers per day who visit Costco stores are some of the most neurologically connected consumers on the planet. Many admit to falling prey to “the Costco effect,” shorthand for spending more than they’d planned to spend. One of those very connected customers, Kimberly Peterson, started a blog in 2006 to share news of what she bought at Costco with her mother and sister. Today, AddictedtoCostco.com has 2 million readers and generates enough ad revenue that Peterson was able to quit her day job and run the site full time.

Costco has immense respect for its customers and, unlike its main competitor Walmart’s Sam’s Club, has lenient return and payment policies. So if you’re unhappy with your six-pound wheel of Brie, you can get a full refund. AddictedtoCostco.com’s Peterson recalls once standing in line behind a man who was trying to return a violin a year and a half after buying it because his daughter didn’t want to play anymore. Costco cheerfully gave him a full refund for the instrument. Financing is made easier. Costco is expanding the number of payment methods it accepts and has added gift prizes for frequent purchasers. For the moment, it only accepts American Express and its own private-label card, but that will change in April, 2016 when it will accept Visa and MasterCard.

Happy Employees, Happy Customers

Though the physical plant might be spartan, the way Costco treats its employees is anything but. At a time when many retailers are cutting staffs and reducing employee hours to cut costs and avoid paying benefits, Costco is an anomaly. It sees employees as an asset to be respected and invested in, not as a cost to be minimized. Former CEO Jim Sinegal once told Stores magazine, “We’ve always had the attitude that if you hire good people, provide good jobs, good career opportunities and good wages, good things will happen in your business.”

Current CEO Jelinek has learned well, and added the consumer into the equation. In 2013 Jelinek wrote to Congress urging an increase in the federal minimum wage for the first time since 2009. “We know it’s a lot more profitable in the long term to minimize employee turnover and maximize employee productivity, commitment and loyalty.” He was also quoted as saying, “It also puts more money back into the economy and creates a healthier country.”

Costco pays its employees an hourly average that is more than two-and-a-half times the minimum wage, and almost twice what Walmart employees make. Almost 80 percent of its employees have company-sponsored health insurance. With initiatives such as these, Costco earns incredible employee loyalty, which in turn results in fantastic productivity.

Other companies that invest in their employees’ workday happiness and loyalty are also performing well financially. Among them are Nordstrom, The Container Store, Sephora, REI and Whole Foods Market. Doug Stephens, founder of the consulting firm Retail Prophet, told Bloomberg Businessweek: “This is the lesson Costco teaches. You don’t have to be Nordstrom selling $1,200 suits in order to pay people a living wage. That is what Walmart has lost sight of. A lot of people working at Walmart go home and live below the poverty line. You expect that person to come in and develop a rapport with customers who may be spending more than that person is making in a week? You expect them to be civil and happy about that?”

Costco’s labor-friendly attitudes date back to its origins. Another philosophy handed down by Sol Price was that he embraced organized labor. While other big retailers like Walmart and Amazon have implemented sizable campaigns to actively keep unions out, Costco is okay with the fact that the Teamsters represent some of its employees.

At Price Club, Sol marked everything up a small flat amount because he felt retailers added only limited value to the consumer purchase equation. He also believed firmly in treating employees, customers and vendors with respect—and in the process, rewarding shareholders. When Sinegal brought the Price Club model to Seattle in 1983 to start Costco, then merging the two and going public in 1995, Wall Street repeatedly begged the retailer to reduce wages and health benefits. Instead, Sinegal, in a nod to his former boss, increased benefits and wages every year, including during the recession. The company’s attitude was “The economy is bad, we should figure out how to give people more.”

To preserve the company culture, it prefers to grow executives from within rather than hiring business school graduates. The many MBAs working at the company earned their degrees while working there. Said Sinegal: “Culture isn’t the most important thing, it’s the only thing.”

Epilogue

My Costco-addicted friend wanted to go on a two-week vacation. Her husband wanted to go to Belize just to chill out. But my friend had a panic attack and demanded, with all kinds of threats, that they vacation in the U.K.—where she could find a Costco when she needed a “fix.” With millions of Costcoholics like her, the behemoth from Bentonville had better be looking over its shoulder.